January Fed Meeting and Higher Rate Expectations
In this article we review:
- Our new base expectation of four quarter-point rate hikes by the Federal Reserve in 2022
- Anticipation of a meaningful reduction in the Fed’s balance sheet
- The impact of additional economic data following the Fed meeting
- The outlook for longer-term interest rates
Against a backdrop of rising inflation and recent downside volatility in the markets, the Federal Reserve held its January meeting, further confirming a new tightening cycle is about to begin.
Given a somewhat more hawkish tone from the Fed, as well as economic and inflation data that has been reported since the meeting, we are now raising our base case expectation to four quarter-point rate hikes by the Fed in CY 2022, therefore concluding the year with a target range on the federal funds rate of 1.00%–1.25%.
Regarding the Fed’s statement, Chairman Jerome Powell’s post-meeting press conference, and additional economic data that has emerged since the meeting, we highlight the following points:
While there was no change in the federal funds rate at this meeting, Chairman Powell provided unofficial guidance that a rate hike in March was likely. This expected rate increase would be the first from the Fed since December 2018 and would also dovetail with the end of the committee’s monthly open market bond purchases originally initiated during the pandemic’s onset in March 2020.
Balance sheet reduction is now officially on the horizon as the Fed prepares to lessen its bond holdings. Along with its statement, the Fed released “Principals for Reducing the Size of the Federal Reserve Balance Sheet,” pertaining to its accumulated Treasury bond and mortgage-backed securities holdings currently standing at just below $9 trillion. While little information was provided on timing or pace of this reduction other than “to reduce holdings over time in a predictable manner,” market expectations seem to be focusing on balance sheet reduction beginning sometime in 2H 2022 at an annual pace of about $850 billion. This would infer about a $2.6 trillion reduction in bonds owned by the Fed over the next three years. The Fed can achieve this through the non-investment, or roll-off, of maturing principal on current bond holdings, likely its first choice, and/or the selling of bonds in the open market.
We believe longer-term interest rates will continue to increase. Amid this environment of higher short-term rates and the Fed’s attrition of bond ownership further out on the yield curve, we see a realistic range on the 10-year Treasury bond yield as being 2.25%–2.50% by year end. In addition, we expect the 2-year to 10-year Treasury bond yield curve to steepen by perhaps about 0.20%–0.40% from current spread levels (0.63% as of January 27).
We believe inflation reports will likely remain hot into 2H 2022, further requiring action by the Fed through the spring and summer months. Since the Fed’s January meeting, the December personal consumption expenditures price index posted a headline year-over-year increase of 5.8% and a core reading of 4.9%, both numbers being their highest levels in more than 39 years. In addition, the advanced estimate for 4Q 2021 U.S. gross domestic product growth was reported well above expectations at 6.9%.
In summary, given our perspectives regarding the recent January Fed meeting and the additional data that has been reported since, we are now expecting four quarter-point rate hikes by the Fed in CY 2022 and therefore concluding the year with a target range on the federal funds rate of 1.00%–1.25%.
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